Common pitfalls in CRE loan portfolios
An examination of the common, yet critical, questions from real estate finance professionals on debt and derivatives structuring and placement.
The challenge of incomplete information
At the outset of a new financing, evaluating the market for the highest loan proceeds, lowest rates, and best terms is a logical starting point. A thorough appraisal should also incorporate the cost of terminating existing debt and derivatives (in either a refinancing or forward hedged scenario), the impact of uncertain future interest rates, and changes to the asset hold time horizon leading to potential breakage costs associated with an early exit or refinancing.
These can be challenging to identify and assess in a vacuum. Getting this analysis wrong may not cause immediate issues, but does introduce increased risks of future unanticipated costs, with a potentially punitive impact to returns.
Common debt and derivatives questions from commercial real estate investors
- Which debt and hedging strategy is most suitable for my business plan? The most thorough approaches compare critical metrics such as effective cost of debt, levered equity net present value, and levered equity internal rate of return. These are calculated across a range of interest rate environments and hold periods. Probability weighting these key metrics toward the scenarios that most closely align with the business plan results in a robust and quantitatively sound result. This allows examination of outcomes and addresses the question: “what happens if things don’t go as planned?”
- How can I more precisely project the path of interest rates over the life of my loan? The path of interest rates over time determines both interest paid and future potential breakage costs. The forward curve is a reasonable starting point, but history would suggest that relying solely on this would be insufficient. A complete analysis will consider a range of interest rates scenarios to draw more accurate conclusions to determine the most appropriate strategy.
- How can I best communicate debt and hedging alternatives and recommendations to a management or investment committee? Converting multivariate numerical analysis from an Excel spreadsheet to a presentation with succinct narrative is challenging. The risk of omitting key details or exposures is high, and the outputs can be complex, making it difficult to draw beneficial conclusions. The best illustrations are usually in graphical form – this can clearly describe key financial inputs, flexed to accommodate alternative interest rate environments, and drawing the reader to the most suitable debt and derivative structures.
- How should I calculate the prepayment or make-whole provisions in my loan? Prepayment and make-whole clauses differ considerably across lenders, jurisdiction, and debt structure. For instance, a fixed-rate loan may come with a considerably different breakage penalty than a floating-rate loan hedged with a pay-fixed swap despite the two having comparable all-in coupons. Correctly addressing the nuances not only requires bespoke calculations on each transaction, but also access to data such as government bond rates or swap rates which drive the calculation.
- Is there a way to access live valuations of my existing derivative positions? Derivative valuations are primarily driven by spot interest rates, volatility, and the prevailing forward curve, which trade live in the open market. The byproduct of this market dynamic is a constantly changing valuation which can move materially depending on the type of product, rate, remaining duration, and market conditions. If the valuation used in a debt and hedging analysis is erroneous, then the output will be incorrect, leading to sub-optimal decisions.
There is no way to guarantee the most appropriate debt and derivative structure for each investment, and each transaction requires a bespoke process reflective of the market conditions at the time. The best processes incorporate sensitizing inputs and assumptions and deploying a range of tools to capture and quantify future uncertainty.
The critical question: are you asking these questions at the outset of a new financing? And do you have the tools to answer them in real time and across your entire portfolio?
Ready to take a step towards technology and advisory that can drive better debt and derivatives decisions?
Schedule an introductory call with one of our advisors.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0090
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